up and down, up and down, repeat

is college worth it? (part 2)

Note: Fecundity took a look at the spreadsheet I used to calculate these numbers and found one formula error and a couple of simplifying assumptions that she refined (she built a more realistic tax calculation, for example). None of the changes affected the conclusion, and in fact it tilted things a bit further in Paul’s favor, so I decided to edit the original article to reflect her changes. Thanks Fecundity!

As I discussed earlier, I’ve been wondering about the difference in wealth between college graduates and skilled non-college graduates. I decided to do a comparison of the two career paths, and see what those big choices meant for someone later down the road. Specifically I wondered if I could answer a few questions:

Can the late start in saving by the college graduate be overcome through higher salaries?

Does the lower earning potential of a non-college graduate mean that the non-college graduate will be required to “work until they die”?

Who will be able to quit the rat race first?

Fred attended college for four years, taking out student loans. Paul got a job at 18, straight out of high school. I wanted to see whether college was worth it, and whether attending college helped or hurt Fred’s chances of getting out of the “rat race,” and whether Paul was facing an unbelievable uphill climb to achieve the same goal.

I made a lot of assumptions. Both men work until age 65. Tax brackets as of 2006 are used (15% to 33%). Both invest in accounts returning 8% per year. Fred starts college at age 18, taking out $40K in loans ($10,000 per year). When he finishes college, he pays back 5% per year ($2000) . He puts aside 10% of his after-tax income for debt and investing. He pays the debt first. He invests the balance of the money. His salary starts at $27,000 and increases 4.5% per year over his life (average annual wage is $80,947).

Paul starts working at age 18. He invests 10% of his after tax income, and has no debt. His starting salary is $8.95 an hour and over his lifetime his average annual wage is $44,895 based on yearly increases of 3.5%.

Here’s what happens. Fred contributes less than 3% of his after-tax income to his investments until he’s 32 years old. He doesn’t invest more than Paul does until they are both 42 years old! His tax bracket jumps to 25% when he’s 26, and by the time he’s 25 he only has $2,000 saved, or approximately 6% of his annual pre-tax salary.

Paul, on the other hand, starts earning and investing when he’s 18. He doesn’t reach the 25% tax bracket until he’s 35 years old. However, at age 35 he has almost $75,000 saved, 231% of his annual earnings before tax.

Fred starts to catch up once his loans are paid off. His investing, starting when they are both 42, is now approaching 1.6 times more per year than Paul. However, by age 50 Paul has $328,000 saved; Fred still only has $164,000. However, since Paul had 4 times as much saved as Fred at age 35, this ratio of almost 2 to 1 is a huge improvement.

As we approach retirement age, Fred is living a pretty good life. His salary is in the mid-six figures at age 60 ($143,000). Paul is making half as much ($76,000). Fred is moving into the top tax bracket, and socking away more than $10,000 per year in savings. Paul is still saving about $500 per month and is just preparing to move into the 28% bracket.

At 65, Fred is making $180,000 per year. He has over $777,000 in savings (4.3 times his salary). His savings in retirement will generate $31,000 per year at 4%, the rule of thumb used for retirement withdrawals for a sustainable amount assuming a normal US life expectancy (78). This means that he will have to live off 24% of his last after-tax salary, plus whatever government benefits or pensions or capital gains from selling his house that he can obtain.

Paul, on the other hand, has more than a million saved ($1,189,000). He NEVER saved more than $600 per month in his whole life. His final salary was $90,000. He will have $47,600 per year (using the 4% rule) to live on; still only 67% of his after-tax salary, but much closer than Fred to a reasonable amount.

Amazingly, Paul only invested a total of $177,000 over his 48-year working life. Fred invested more: $231,000. Yet Paul’s final portfolio contained 7 times more cash than he invested; Fred’s was only 3.36 times as much as he invested.

Paul ends up with $412,000 more than Fred. Paul, at age 65, has a far better chance of surviving in comfort off his $1 million portfolio and a lifestyle presumably suitable for someone who makes less than $100,000 per year. Fred, on the other hand, will struggle to survive if he maintains a lifestyle built around a $180,000 per year salary with only $777,000 in the bank.

Now Fred, of course, may have bought a house in a metropolitan area when he was 40 and now can sell it for hundreds of thousands in profit; however, I’m willing to bet that unless he was highly disciplined he still has a mortgage, and the chances of making over $400,000 in profits on a home are small (not impossible – but small). Fred may also have had access to tax-advantaged plans and matching programs through company 401(k)s and so forth that Paul might not have had. Even if all of these scenarios play out perfectly for Fred, he barely catches Paul. Even if he DID have $1.3 million saved, it’s still only enough to guarantee 29% of his after-tax retirement income.

So what does this all mean? Should every 18-year old skip college and go straight into the workforce? The short answer: no. Assuming that you did start earning at 18, you would need to be a highly disciplined saver, and not everyone is. If Paul didn’t start saving until he was, say, 29, he has only $665,000 in savings at age 65. Those extra 10 years after high school – when he saved only $18,000 – made an almost half million dollar difference at the end of his working life. Ask yourself how many people at age 18 can save 10% of their salary. They exist, sure, but realistically very few people have that discipline.

What’s the solution, then? I think if you go to college, avoid student loan debt if you can. How? Don’t go to an expensive school if a less-expensive option is available. If Fred’s student loan for $40,000 disappears, he has $1.3 million when he retires. Still not enough, probably, but $650,000 more than he would have had. That debt makes a huge difference.

A second tip is start investing early. Very small amounts invested early in your life will grow significantly more than the same amount (or an even greater amount) invested later. If you managed to save a few hundred dollars in high school, that’s far more significant than thousands when you’re in your 40s. Think about that – a tiny bit of sacrifice early on will make you richer than a much larger sacrifice later in life, when you think you have “too many expenses.”

A third lesson: consumer debt will cripple your chances of accumulating substantial savings. I assumed both men were exceptionally disciplined and never incurred any debt other than student loans (in Fred’s case). If either one had spent that 10% per year on credit card debt instead of investing it, their future prospects for quitting work before death plummet to almost zero.

A final lesson: even small amounts make a huge difference. Think again about this statement: “He [Paul] NEVER saved more than $600 per month in his whole life.” Isn’t that amazing? Not one month in his life did he ever save more than the cost of an iPhone plus accessories, or much more than digital cable plus cell phone service. He didn’t save thousands per month, just $600. If that’s not enough, keep in mind that was the absolute maximum he ever saved in a month! On average, he only saved around $300 per month over his life!

Here were my original questions, and the answers I discovered:

Can the late start in saving by the college graduate be overcome through higher salaries? Not really, unless the college graduate’s salary is significantly higher or the savings rate is substantially greater.

Does the lower earning potential of a non-college graduate mean that the non-college graduate will be required to “work until they die”? Absolutely not – in fact, if the non-college graduate is a disciplined saver, the opposite is true.

Who will be able to quit the rat race first? Based on my model, the non-college graduate – but the real indicator is who starts saving the highest percentage of their income earliest in their career.

Don’t take too much of this as gospel. This was an illustration only, and of course a million variables come into play about spending habits, debt, housing, career growth, investing choices and so on. The purpose of this exercise was to challenge my context, and hopefully yours too. Don’t always assume that just because the college presidents of America tell you that you need college that you do. I had a lot of good times in college, and I wouldn’t trade them for anything. But don’t kid yourself – colleges are businesses that want your tuition to fund their foundations and football teams and new buildings and conferences and so on. They want you to take out big loans, because they don’t care that you start your earning life saddled with debt as long as they get their tuition revenue.

The moral of the story is that you shouldn’t believe a thing just because everyone else says it’s true.

19 comments

Interesting comparison… Did you play with your number to find out what would be the result if Fred was starting at 35K? or 40K? I don’t know about the states, but starting at 35-40K is definitely not impossible in Canada after getting a bachelor degree. I personally started at 30K and by the end of the very same year I was making 42K.

With the cost of living, I highly doubt that Paul will be able to save 10% of his income. Chances are that he will borrow 10% of his yearly income every five years to keep up with his lifestyle 😉

I don’t think Paul would finish with any close to 1M$ since I hardly know people that are able to save with $9/hour starting salary.

The main reason is because the fixed expenses (such as rent) will be more likely to be the same amount in term of dollar for Fred and Paul but will be a lot more different percentage wise. As an example, a $500 rent a month on a $27,000 year salary is 22% of Fred’s before tax income. The same rent on a $18,616 (40hrs @ $8.95) is 32% of Paul’s before tax income.

If you add up food, transportation and utility bills (they should be the same for both of them), my bet is that Paul will be left with nothing but debts at the end of the year 😉

@TFB: If Fred starts at 40K, then he ends up at 65 with almost $1.3 million. I chose 40K because I looked at some salary statistics and that’s an average starting salary for a “finance analyst.” I’m sure in big cities it’s more, small cities less. One of the big variables would of course be where they lived. If Paul and Fred both lived in a big urban area – Chicago, Toronto, New York – the cost of living would be prohibitive because cheap rents would only be available with horrible, long expensive commutes, so Paul would be a significant disadvantage early on. In smaller towns it might flatten out – where I grew up, in a town of 10,000, the cheapest places to live and the most expensive were all within 15 minutes of the town center. You’re right – the discipline to save 10% of your income is tough when you make very little, but judging by most of the statistics I read, making a lot of money doesn’t make people more likely to find it easy to save 10%, either! Maybe the argument is in favor of finding less expensive places to live…

@plonkee: Yep, yep, yep. Your statement is 100% true. Wealth and income are two different things – people with low income can be wealthy, and people with high incomes can have a low net worth. It’s having the discipline to save SOMETHING that makes all the difference.

When I was 18, I was making a min. wage of $5.50 – $6.00 living in NYC with my parents. I managed to have $800 in my bank account within one year. Plus, I still spent on some clothes and accessories like any normal girl would.
Everything is possible, if you are disciplined enough to save and invest early on.
When I graduated from College I was offered $50K + $10 signing bonus my first year. That was very unusually high, whereas my fellow graduates were getting offers $35-$40K at best. BUT, I didn’t start investing in my company’s 401(K) till a year later. Not because I was not disciplined but because I didn’t know anything about 401(k) and investing. Sounds funny for someone who majored in Finance and Investments.

@FourPillars: Mike, glad you liked it. Your right, Fred probably does have a much higher standard of living during that time period, although I would counter by saying that if they were to retire at the same total level of savings (i.e. both stop once they’ve saved $500,000 or whatever) Paul could have spent a lot more along the way.

I have to disagree completely about who can save a higher percentage of their income! Anyone can save higher or lower percentages of their income – your income level has very little to do with it after you’re making enough for rent, etc. Fred might have a lot more income, but if he’s got a higher standard of living – like you mentioned – then he probably spends 90% or more of his after-tax income, just like Paul. I know people who make much less than I do who still save as much or more than I do, and I know people who make a LOT more who save almost nothing. Fred has an opportunity, sure, but so does Paul – it’s all just relative to the level of comfort you require. I also know people who make as much as I do but live a substantially simpler lifestyle in cheaper locations, and therefore save a lot more.

I could go on and on but I think there’s a thought process that says people with low incomes can’t save – there’s some magic number over which saving gets “easier.” There isn’t – 99.9999% of the people in North America try to live up to the level of their income. If I could travel back in time to tell 1994 Steve how much he would make now, he would be blown away and figure he could save 50% of his income – but instead, even living a very frugal lifestyle (we save about 25% of our net income) there are a million ways I could cut back further, and don’t, because I don’t want to face life without Netflix … for example.

By the way, if anyone wants the actual spreadsheet I’ll be glad to email it to you – although I didn’t do a lot of labeling or explanation, so it may take a while to puzzle out! Just use the contact form or email me at bripblap—at—gmail * com.

One point you didn’t mention is that during their working years, Fred (college dude) would have a much higher standard of living than Paul which has to be worth something.

One other key point (and I know there are 14 million possible scenarios) is that you assume both men save the same amount of after-tax income which is a valid assumption but the fact is that Fred (college dude) has the opportunity to save a much higher percentage of his after-tax income than Paul does which if taken advantage of, might tip things toward Fred.

I hear what you are saying but I still have to disagree. FB noted quite accurately in the first comment that someone making about $18,000 will have to spend a large portion of their net income just to stay alive. As you pointed out, the region where they live will make a big difference.

Someone who lives alone in a bigger city and makes $18,000 / yr does not have the same opportunity to save as the comparable person who makes $45k/yr. I also don’t agree that most people will live up to their salary. Most people I know do raise their standard of living as they make more money but they also raise their savings rate as well.

To Mike (Four Pillars) comment to SavingDiva: ditto! 24 is still a looong way ahead of most of the population.

Mrs. Micah: you’re right, and the argument can be made that a lot of people “waste” their college years pursuing, say, an art history degree only to get a job in banking. I say “waste” because, of course, that’s all part of the journey that got you from point A to B and therefore it’s never really a waste 🙂

I like plonkee’s comment that it’s what you keep that matters. Another important question is whether they were able to do what they wanted with or without college. I.e. Micah’s telos is to teach people–specifically to teach them how to think (not what, but how). And he can’t really do that without a PhD in philosophy. Me? I think my debt-free education enriched me, though I could have probably done without it.

Actually, I think that Paul (the non-college guy) is probably spending about the *right* amount for his income. I mean the standard rule of thumb is that you need two-thirds of your salary in retirement.

If you spent 4 years at college and accumulated debt, then you need to save a lot more than 10% of your salary to maintain the constant (but slightly lower) level of expenditure throughout your life and into retirement.

This is a really useful baseline model, but as you point out there are some many simplifying assumptions. Two key factors that will influence outcomes but are difficult to plug in to the model are what opportunities present themselves to Paul and Fred, and how they really go after those opportunities.

One take away for me from this model is that if you are going to go to college do it sooner rather than later in life to minimize your oportunity cost.

I went to business school in my early 30’s, so I had the opportunity cost of real lost income and lost savings ability at school before getting back into the workforce. I’m not likely to make a substantial financial return on my education investment for a long time. I basically made a huge bet on future earnings potential which becomes very risky.

However, given the volatility in the world of work today, education may at least buy an individual some level of improved choice in response to changes in the job market.

Great little exercise, but I have to admit, I found it useful for only one thing – the comment someone made earlier about what you keep. If Fred put away more of his income and didn’t live like he earned $180K, he’d likely be better off than Paul in retirement. And the chances that Paul is saving 10% are pretty close to nil, even in a small town. His chances of not having debt are smaller. Statistically, those without a college education are more likely to file bankruptcy (as well as those who make less than 30K)
While your Fred is unfortunately realistic, your Paul is unfortunately not.

And something got missed. It’s not always about where you end up, but also about how you got there and what you did along the way. College is expensive, but there are intangibles that are priceless, like experience and opportunity.

All that being said, I agree with your conclusions, and would add another – if you do choose the more expensive school, be both frugal and creative. There’s nothing wrong with working through college to help minimize the loan too.

Oh and regarding:
“I could go on and on but I think there’s a thought process that says people with low incomes can’t save – there’s some magic number over which saving gets “easier.” There isn’t – 99.9999% of the people in North America try to live up to the level of their income.”

Actually, there is – it’s 40K. I know you read Penelope Trunk too. 🙂
But sadly you’re right, most people aren’t really saving that extra income, but trying to spend it as fast as they can.

I am an advocate of getting at least a bachelor’s degree. Unfortunately, most people go into debt for it. Even so, I think of it as an investment. I got a bachelor’s degree in English back in the dark ages, then chose to be a stay at home parent for 16 years. That degree was my ticket back into the work force. Granted I didn’t have nearly the amount of debt coming out of school as today’s graduates do, but without that degree I not have been able to apply for the job I have today.

I’m certainly in agreement with any statements about my overgeneralizing and making broad assumptions. It’s certainly nowhere near to a perfect model. Like Deepali said, a lot of studies (via Penelope, one of my favorite writers!) indicate that $40K is the breaking point for being able to save, be happy, etc. So if you assumed someone making less than $40K was unable to save effectively, that would change the model.

I’m not sure it comes across clearly, but my takeaway was the same as plonkees and JimB’s and everyone else’s: get an education early, do it without incurring debt, start saving early. If you do that, you’re better off…period. “Paul” does better only because he starts earlier. If Fred doesn’t have loans, the model lurches massively back over in his favor. The trick is to start saving very early – and that’s really the moral of the story.

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